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Slide Sets to accompany Blank & Tarquin, EngineeringEconomy, 6th Edition, 2005

© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved1-1

Developed By:Dr. Don Smith, P.E.

Department of IndustrialEngineering

Texas A&M University

College Station, Texas

Executive Summary Version

Chapter 1

Foundations OfEngineering Economy

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LEARNING OBJECTIVES

1. Questions

2. Decision making

3. Study approach4. Interest rate

5. Equivalence

6. Simple andcompoundinterest

7. Symbols

8. Spreadsheetfunctions

9. Minimumattractive rate ofreturn

10.Cash flows

11.Doubling time

12.Spreadsheets

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Sct 1: Why Engineering Economy isImportant to Engineers

Engineers “design” and create

Designing involves economic decisions

Engineers must be able to incorporateeconomic analysis into their creative efforts

Often engineers must select and execute frommultiple alternatives

A proper economic analysis for selection andexecution is a fundamental aspect ofengineering

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Engineering Economy

The art and science that involves:

Formulating,

Estimating and Evaluating economic outcomes

Always concerned with the selection and

possible execution of alternatives given theeconomic parameters associated with theproject

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Sct 1.2 Role of Engineering Economy inDecision Making

Decision making involves the estimation offuture events/outcomes

Engineering economy aids in quantifying pastoutcomes and forecasting future outcomes

Engineering Economy provides a frameworkfor modeling problems involving:

TimeMoney

Interest rates

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The Decision Making Process

1. Understand the problem – define objectives2. Collect relevant information

3. Define the set of feasible alternatives

4. Identify the criteria for decision making

5. Evaluate the alternatives and applysensitivity analysis

6. Select the “best” alternative

7. Implement the alternative and monitorresults

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Time Value of Money

All firms make use of investment of funds

Investments are expected to earn a return

Investment involves money Money possesses a “time value”

The “time value” of money is the most

important concept in engineering economy

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Sct 1.3 Performing An EngineeringEconomy Study

Engineering Economy Studies:

Define Alternatives

Do-nothing alternative – maintain the status quoDefine feasible alternatives – that can solve the problem

Define/estimate the current and future cash flows

Perform the analysis

Apply the tools and methods of engineering economy

Selection of the best alternative

Implement and monitor

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Sct 1.4 Interest Rate and Rate of Return

Interest – the manifestation of the time value of money

Rental fee that one pays to use someone else’s

money Difference between an ending amount of money and a

beginning amount of money

Interest rate (%) = interest accrued per time unit x 100%original amount

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Rate of Return

Interest earned over a period of time is expressed asa percentage of the original amount, specifically;

interest accrued per time unitRate of return (%) = x 100%original amount

Borrower’s perspective – interest rate paid Lender’s perspective – interest rate earned

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Sct 1.5 Equivalence

Different sums of money at different timesmay be equal in economic value

0 1

$100 now

$106 one

year from now

Interest rate = 6% per year

$100 now is said to be equivalent to $106 one year from now, ifthe $100 is invested at the interest rate of 6% per year.

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Sct 1.6 Simple and Compound Interest

Simple Interest:

Interest = (principal)(number of periods)(interest rate)

Compound Interest: Interest earns interest on interest

Compounds over time

Interest = (principal + all accrued interest) (interest rate)

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Sct 1.7 Terminology and Symbols

P = a present sum of money at a timedesignated as t = 0 { t represents time}

F = a future amount of money at some point in

time later than t = 0 A = a series of equal, end-of-period cash

flows

n = the number of interest periods i = the interest rate or rate of return per time

period, in percent

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Sct 1.8 Introduction To Solution ByComputer

Application of Microsoft’s Excel spreadsheetprogram

Excel financial functions

Present Value P: =PV(i%,n,A,F) Future Value F: =FV(i%,n,A,P)

Equal, periodic value: =PMT(i%,n,P,F)

No. of periods: =NPER((i%,A,P,F)

Compound interest rate: =RATE(n,A,P,F) Compound interest rate: =IRR(first_cell:last_cell)

Present value of a series: =NPV(i%,second_cell:last_cell) + first_cell

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Sct 1.9 Minimum Attractive Rate of Return

Investors expect to earn a return on theirinvestment (commitment of funds) over time

We expect to see economic efficiencies greaterthan 100%

A profitable investment should earn (return)funds in excess of the investment amounts

Economic projects should earn a reasonable

return, which is termed:MARR – Minimum attractive rate of return

Also termed the “hurdle” rate for an investment

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The MARR

The MARR is established by the financialmanagers of the firm

The MARR is expressed as a percent value Most, if not all, projects should earn at a rate

equal to or greater than the established MARR

MARR’s are set based upon: The cost of all types of capital

Allowance for risk

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Types of Financing Equity Financing – the firm uses funds either

from retained earnings, new stock issues, orowner’s infusion of money

Debt Financing – the firm borrows funds from

outside sourcesThe cost of debt financing = the interest rate

charged on the debt (loan) amounts

The MARR is approximated from the weightedaverage cost of all sources of capital to thefirm

A firm’s ROR > MARR > cost of capital

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Sct 1.10 Cash Flows: Their Estimation andDiagramming

Definition of termsCash Inflows - amount of funds flowing into the

firm

Cash Outflows – amount of funds flowing out of thefirm

Net Cash Flow equals

cash inflows – cash outflows Assumption for analysis – end of periodFunds flow at the end of a given (interest) period

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Cash Flow Diagrams

A typical cash flow diagram might look like:

0 1 2 … … … n-1 n

1. Draw a time line

One time period

0 1 2 … … … n-1 n

2. Show the cash flows

Cash flows are shown as directed arrows (+ for up or – for down) ---

(+) inflow; (-) outflow

Always assume end-of-period

cash flows!

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Sct 1.11 Rule of 72: Estimating DoublingTime or Interest Rate

Common question:Estimate the number of time periods it takes for a

cash flow to double in size

Given an interest rate i% per period

The approximate time n for an investment at time

t = 0 to double in value is given by:

n = 72/i

e.g., $10,000 at 7% per year doubles to $20,000 in10.3 years

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Sct 1.12 Spreadsheet Application

Reference Example 1.18

Design a spreadsheet model to evaluate this

project Illustrates simple interest, compound interest and

inflation

Focus on the overall design of the model and the

associated formatting

Check appendix A for hints, formats, formulas touse a spreadsheet effectively

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Chapter Summary

Engineering Economy – application of economicfactors and criteria to evaluate alternatives Applies the time value of money

Application of economic equivalence

Introduction of the MARR

Cash flow estimation Modeling – cash flow diagrams

Difficulties in estimation

Perspectives – viewpoints taken

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End of Slide Set

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